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Many people own or trade stocks. Investors use fundamental analysis to choose a stock to purchase in hopes that it will go up in value. Some purchase a stock for the income it may provide via dividends. Traders purchase or sell stocks based on technical analysis buying and selling often on movement or volatility in the stock price. These are all very basic and your 401K and IRA’s do the same thing depending on which one you chose your broker to invest in.
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A more advanced and even more conservative stragety however is to “write a covered call”. This means to sell a contract on the stock that you already own. This will produce an income even if the stock price stays the same, or even goes down in value that month. It also helps to hedge, or offset the downside numbers in your account if the stock price does go down that month because although your stock went down in value by say 2%, you may have received 1% in income from selling the covered call.
This is how it works; lets say you own 100 shares of xyz stock. You bought it a while ago at $50/ share. The price is now $60/ share. Instead of selling the stock to actually realize a profit, because it may continue to go up in price as the years or months go on, you choose to write a covered call. This means that you sell a contract to a person, they pay you an agreed upon price to purchase the stock at any time they choose in the next month (or longer if you wish, for a higher premium of course). So you bought the stock at $50, its already at $60, and you sell a contract to sell it to someone at $65. For this they premium they pay you for that privilege (contract) may be $.25. These are all multiplied by 100 so you would recieve $25 income to agree to sell your stock to them at $65 in the next month.
So, if the price does reach $65 or higher the buyer of your contract will “exercise” or buy it from you at the agreed upon price of $65. That means you made a profit of $15/per share plus $25 for the agreement (options contract). Pretty good deal right. You locked in a price to sell it at a profit and got money (income) to do it. If the price never reaches $65 then you keep your stock and the $25 and do it again month after month. And the great part is that if your stock keeps climbint every month, you simply move your agreed upon selling price up, guaranteeing you more profit and still get the income.
An example would be, you did exactly the above for this month. Your xyz stock price did go up, but it only went up to $62.50. This means the purchaser of your contract will certainly not buy yours at $65 when they can buy it on the open market at $62.50 So you keep his money, and the contract expires on the third friday of every month. Now that your stock price has moved up, this month you sell the contract for the same price ($25), but this time you agree to sell your stock at $67.50 instead of $65! Sound pretty good eh? It is. Its a smart and more conservative way to own a stock rather than to just buy it and hold it.
Now we get to the more advanced move. We create what is called a Collar. This means we own the stock, sell the covered call as above, but instead of pocketing the $25 premium for the contract we put it to work opening another position (opportunity) for us. We already own the stock, the $25 was free, so we take that money and we buy a call option. This means that if the stock price goes up, we not only sell our stock at a profit, but we also sell our options contract at an option, and we bought this option with the money we sold the contract to sell for. So lets look at what happens.
If the stock price goes up, but doesnt reach $67.50 then we keep your stock, and we sell our call option that we bought at a profit, and it was paid for by the selling of the other option contract.
If the price of our stock doesnt change, we keep our stock, and both options contracts expire costing us nothing.
If the stock price rises above $67.50/ share; We sell our stock at a nice profit, and we also sell our call option we purchased at a profit as well, getting to profits off of one stock position.
If the stock falls in price this month; we keep our stock, and both of our options contracts expire without any money plus or minus.
graph from http://collars.optionetics.com/collars.aspx
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